Guest Post: Regulators Are Encouraging Banks To Game Risk Models

Two interesting articles were published yesterday discussing how banks in Europe are resorting to clever tricks that artificially raise their loss-absorbing capital to levels specified by regulators. They’re doing this especially to hit the level of 9% core capital-as-a-percentage of risk-weighted assets that the regulators require as a response to the most recent stress tests. While actually selling loans and exposures would be one way to achieve this so-called “risk-weighted asset optimization”, it looks like many banks are actually just choosing to fiddle around with the internal, self-created risk models that both the current Basel II and the not-so-new-and-improved Basel III regulatory regimes allow them to use. Yes, these regulatory regimes allow the banks to decide, for themselves, how risky their loans are. Which of course then drives how much or how little loss-absorbing capital they must hold. Don’t worry, though, because the regulators approve the models on a yearly basis.

“Santander said it planned to increase capital by 4 billion euros by optimizing risk-weighted assets and internal models. BBVA said the total effect of revising its model was expected to be 2.1 billion euros of additional capital.”

I haven’t yet come across an instance of a bank having to increase its count of risk-weighted assets due to its model changes. Funny how it seems to move in one direction only. For example in Fears rise over lenders’ capital tinkering the Financial Times notes that Lloyds has, through a combination of selling and model-tinkering, dropped its 2010 risk-weighted assets by a whopping £16 billion. With the blessing of UK regulators.

And why might the regulators be so approving of such dubious and artificial tactics? Well, sorry to say, we’re in a little bit of a hostage situation at the moment. The banks are reluctant to raise capital on the equity markets because 1) their share prices are already in the toilet and 2) issuing shares to new investors would make current investors unhappy. (Although, probably not as unhappy as if the bank were to collapse for failing to hold enough capital to absorb its losses.) Meanwhile people are deathly afraid that the banks will cut off credit to small business sector. (That is, any more than they already have.) Have a look at what Andrew Haldane of the Bank of England said in a speech yesterday:

”‘There is a strong argument for making risk weights dynamic and real-economy focused. At present, they are calibrated to the risk to a bank. In future, they need to reflect returns to society,’ he was quoted as saying.”

And he’s not a politician, but a regulator. In fact, he is the Executive Director of Financial Stability. And Haldane, in my opinion, generally has the right idea about banks and their risks. Which are risks not just “to themselves” but to all of society and the global economy. Yet here Haldane’s endorsing the sort of sleight of hand that banks are all too ready to perform with no encouragement. Not a good sign.